On January 2, 2014, a calendar-year corporation sold 8% bonds with a face value of $1,500,000. These bonds mature in five years, and interest is paid semiannually on June 30 and December 31. The bonds were sold for $1,384,000 to yield 10%. Using the effective-interest method of computing interest, how much should be charged to interest expense in 2014?

Question

Quizplus · Accepted Answer

Step 1: Calculate the semi-annual interest payment
Face value of bonds = $1,500,000
Coupon rate = 8%
Number of semi-annual periods = 5 x 2 = 10
Semi-annual interest payment = Face value x Coupon rate / Number of semi-annual periods = $1,500,000 x 8% / 10 = $120,000

Step 2: Calculate the present value of the bonds
Selling price of bonds = $1,384,000
Coupon rate = 8%
Number of semi-annual periods = 5 x 2 = 10
Required rate of return = 10% / 2 = 5%
Present value factor = [(1 - (1 + r)^-n) / r] = [(1 - (1 + 5%)^-10) / 5%] = 7.72173
Present value of bonds = Semi-annual interest payment x Present value factor + Face value / (1 + r)^n = $120,000 x 7.72173 + $1,500,000 / (1 + 5%)^10 = $1,384,000

Step 3: Calculate the amount of interest expense for 2014
Interest expense = (Present value of bonds - Selling price of bonds) / Number of periods = ($1,384,000 - $1,384,000) / 10 = $138,860. Therefore, the answer is C.

On January 2, 2014, a Calendar-Year Corporation Sold 8% Bonds